MONEY THOUGHTS: Neuroeconomics and surprise

So to prosper, stay informed and flexible. Accept that you can’t predict the future... but that you can train yourself to stay calm, loose and wise by always expecting change and expecting to be surprised.

If that last bit triggered within you a stir of surprise, you’re normal.

We human beings, far more than any other lifeform on Earth, are pattern-recognising experts.

That’s good because it has helped us survive and become the dominant species on our beautiful planet.

However, we are also a pattern-seeking species. This means we try to find predictable occurrences even when there is no true underlying pattern, which can be dangerous.

Imagine a prehistoric hunter noticing for perhaps six days in a row that whenever the sun is high in the sky, no carnivorous predators are to be seen.

Then, as a result of faulty reasoning built on his innate need to seek out patterns to make sense of his world, our hunter believes no vicious animals at all roam the savannah at noon.

Therefore, he may unconsciously disregard normal cues like musky scents, low growls and the distant rustling of grass, which raises his likelihood of encountering a prowling, peckish sabretooth tiger wanting a snack.

We grow surprised when the unexpected occurs. And often the unexpected hits us so hard because of our tendency to seek out patterns even when there is no genuine pattern-generating principle at play.

Right now, I would like you to focus on our well-developed pattern seeking predisposition as we fast forward to our 21st century.

Imagining patterns

In our era, we may inflict upon ourselves significant financial harm if we first imagine a pattern exists, say in a series of rising stock prices over a short period, and then make unwarranted assumptions that the upward sloping price trend line will continue because of so-called “technical factors” without taking a cold, hard look at the more crucial fundamentals of the company in question.

When large hordes of speculators act that way, even a tiny miss in reported sales and earnings — if unexpected — can result in outsized investor capitulation that leads to huge, irrational sell-offs.

What’s interesting is that that lofty quoted price came after a near one-for-one stock split in March 2014, which would have resulted in a shareholder with 1,000 Google shares before the split owning 1,998 shares after it.

Simply put, a previous owner of 1,000 Google shares ended up owning almost 2,000 Alphabet shares. So without that 2014 stock split, Google would have been priced at about US$1,900 (= US$950 x 2) per share!

That’s a staggering 2,100 per cent increase in its share price from its 2004 US$85 IPO (initial public offering) over just 13 short years.

Sadly, because both life and investing are messy, anticipated intermediate price patterns never pan out the way we expect. When that happens, people’s reactions to adverse surprises can be excessive and ultimately damaging to their long-term wealth building initiatives.

In Jason Zweig’s 2007 book, Your Money & Your Brain, he grants us insights into what happened 17 months after Google was listed in August 2004:

“On Jan 31, 2006, Google Inc. announced its financial results for the fourth quarter of 2005: revenues up 97 per cent, net profit 82 per cent.”

As great as those results were, even better numbers had been expected by analysts. So first came widespread investor surprise, followed by irrational panic: The stock fell 16 per cent in seconds.

As Zweig points out: “Google earned about US$65 million less than Wall Street had expected, and in response Wall Street bashed US$20.3 billion off Google’s market value.”

Later Google’s share price recovered and moved from strength to strength. But those who reacted adversely in 2006 to the surprise of a slight “earnings miss” irrationally acted like lemmings, rushing off a cliff in their mass dumping of one of the greatest investments in the world.

Expect to be surprised

What is it in our heads that causes us to act this way?

According to Zweig: “Humans and great apes are the only land mammals that have specialised neurons called spindle cells in a central forward region of the brain known as the anterior cingulate cortex, or ACC. Humans have at least twice as many spindle cells in this region as the great apes do. The ACC also assists in generating the feeling of surprise when your normal expectations are shattered.”

Now, ask yourself: Was all that selling of Google shares done as one-sided trades?

No!

There would also have been those who bought from the panicked sellers. Those brave souls had the same type and number of spindle cells in their brains as the rest of us, yet reacted very differently to the same stimulus of a negative surprise.

As a result of their “well placed” courage, they made a fortune in the years ahead.

The opportunities of tomorrow will not merely be those of yesterday. But they will exist.

So to prosper, stay informed and flexible. Accept that you can’t predict the future... but you can train yourself to stay calm, loose and wise by always expecting change and expecting to be surprised.